This Famous Method of Valuing Stocks Is Pointing Toward Some Rough Years Ahead
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“Uncharted territory” is a phrase investors hear a lot these days. There are, in fact, updated charts out there, and they point to some difficult times ahead.
Consider what seems like one of the clearest comparisons of how much we pay for a piece of the world’s largest, most-rewarding stock index. As of last week, its multiple of sales was higher than at any point in history, including the peak of the tech-stock bubble.
In part, though, that just reflects the U.S. economy’s transformation. Microsoft has an operating margin about five times as high as Exxon Mobil and 10 times that of retailer Walmart. Asset-light companies make up a lot more of the index than they did in the past and they earn a lot more profit on their sales.
But the “companies are just better” excuse starts to wear thin when the gold standard of valuation enters the discussion. Rather than the forward-looking price/earnings ratio based on analyst forecasts and favored by most fund managers, that is the cyclically adjusted version first proposed by Warren Buffett’s mentor Benjamin Graham.
It is sending a clear signal: Expect paltry stock returns in coming years.
The version popularized by Nobel Prize-winning economist Robert Shiller looks back at 10 years of earnings and adjusts them for inflation to cover an entire business cycle. It recently broke above 40 for the second time ever.
The first was in 1999, and it didn’t stay there long. Cyclical peaks in the Shiller P/E have coincided with negative real (inflation-adjusted) returns for stocks over the ensuing 10 years, including in 1929, 1966 and 2000.
The soundest argument for dismissing today’s nosebleed Shiller P/E is that 40 isn’t as high as it sounds. The long-run average has been around 17.
Shiller’s measurements begin in 1881 when the U.S. was more like an emerging market and stocks were widely manipulated. Starting in 1990 instead, when computers and CNBC were around, is fairer. The average since then has been 27 times.
But another case for dismissing the Shiller P/E—that companies will just keep getting more profitable—makes no sense. Corporate taxes are now low and labor’s share of economic output is too. Amid massive federal government budget deficits and an aging population, those trends can’t continue and might reverse.
And what about today’s wonder technology? If artificial intelligence unleashes a productivity miracle, that could grow the size of the whole pie.
But its impact would have to be truly transformational and long lasting just to bring valuations back to average.
Something’s gotta give. And, with the Shiller P/E now higher than it has been 99% of the time, it will have to be the “P” more than the “E.” Some consolation, though: Other stocks look more promising.
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Index developer Research Affiliates has a model that forecasts future returns for investments based on cyclically adjusted P/E ratios. Its model gives the U.S. the benefit of the doubt on measures like economic growth. Its calculations call for large U.S. growth stocks such as the Magnificent Seven to have a negative 1.1% real return over a decade while large value stocks could eke out a positive 1.6%.
The picture brightens for small U.S. stocks, which have an expected real return of 4.8%. European and emerging-market stocks look a little better at 5% and 5.4%, respectively.
The Shiller P/E isn’t necessarily a timing tool and can stay elevated for a long time. Zoom out, though, and it does an impressive job of steering investors away from dangerous shoals.
Write to Spencer Jakab at Spencer.Jakab@wsj.com
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